April 1, 2010Evidence mounts that the U.S. economy is moving away from the depths of the Great Recession. The U.S. economy expanded at a 5.6% annual rate in the fourth quarter of 2009, and corporate profits surged. Though unemployment stands at 9.7%, it has not increased since it hit a 26-year high of 10.1% in October 2009. There are indications that the jobs picture may be improving as well. Last week the Labor Department reported that new claims for jobless benefits dropped to 442,000, the smallest weekly total in six weeks. The number of U.S. citizens seeking unemployment benefits dropped to 4.65 million, the lowest in over a year. Many economists expect that March will witness the biggest increase in U.S. payrolls in three years. Inflation has remained in check with the year-over-year increase in February’s core consumer price index (CPI) of 2.1%. The U.S. stock market has responded favorably to the current environment, with the Standard & Poor’s 500 Index1 climbing more than 5% since calendar year-end (through March 30). Tempering the “glass is half full” view is that the pace of economic recovery so far has been more akin to the lower growth rates following the U.S.’s two relatively mild recessions of the early ‘90s and 2000s than the higher growth rate following the more severe downturn of 1981-1982. Moreover, the Federal Reserve (the Fed) continues to emphasize that the unemployment picture in the U.S. remains very weak and that the labor market justifies low interest rates for “an extended period.” Herein is the challenge for U.S. policy makers. No question that record monetary and fiscal stimulus took the U.S. economy out of a tailspin. The consequences, however, are that the plan to avert Great Depression II needs to be followed with a surgical “unwinding” of monetary expansion and fiscal stimulus policies. An “unwind” which is too abrupt could choke off the recovery. One which is delayed could lead to higher interest rates and rising inflation. Indeed, the Great Unwind is already beginning. The Fed has slowed its purchases of mortgage-backed securities (MBS), and, having purchased up to $1.25 trillion of these securities over the past year and a half (doubling the size of its balance sheet), it ceased buying them altogether at the end of March. Fed Chairman Bernanke has also expressed his desire to actually reduce the Fed’s MBS holdings (that is, sell some) in a measured way. If not done carefully, the risk is that higher mortgage rates could result and possibly jeopardize recovery in the all-important U.S. housing market. The portion of the government’s TALF lending program dedicated to jump-starting the securitization market for credit-card and car loans also wound down in March. In hindsight, this program may be one of the more successful government initiatives as it has led to the opening of the non-government supported securitization market for consumer credit. With respect to draining excess liquidity, the Fed has several tools at is disposal. These include entering into reverse repurchase agreements with banks (in which the Fed sells securities from its now $2.2 trillion portfolio, with an agreement to buy them back later), selling “term deposits” with maturities of up to one year to banks (thus encouraging the banks not to lend excess reserves) as well as the traditional approach of raising the federal funds target rate. Notably, the only question will be when to pull the trigger on any of these options. The Fed has signaled that it may exercise the first two before explicitly raising short-term rates. Reigning in fiscal spending is likely to be a bigger challenge for the administration and Congress than the Fed’s task to manage the money supply (which, from a political perspective, won’t be easy either). If little progress is made in either area, the U.S. bond market will not be sympathetic. Witness what has happened to the cost of sovereign debt in Greece. The Greek risk premium over German debt has increased significantly due to concerns over the size of its debt level relative to its economic productivity level. The U.S. (and U.K. for that matter) may not be in such an extreme predicament as Portugal, Italy, Ireland, Greece and Spain, but, with a debt to gross domestic product (GDP) ratio approaching 100%, it is no longer out of the question that foreigners may find U.S. debt securities less attractive at current yields. One needs to look no further than the behavior of the U.S. bond market last week when the Treasury auctioned just over $100 billion in two-, five- and seven-year notes. Demand was weaker than expected, likely reflecting investor concern over the rising deficit and/or greater interest in other higher-yielding assets. Whichever the reason, demand from buyers (including foreign buyers) dropped and led to a 15 basis point (0.15%) spike in the yield of the 10-year U.S. Treasury Bond to 3.85%. In summary, and reflecting upon the historic events of the past three years, it was rapidly deteriorating credit markets that led us into the Great Recession. Rebounding credit markets have helped lead us out. Now we find ourselves at a point where if the appropriate monetary and fiscal “unwinding” steps are not taken (or at least a plan to unwind formulated), the U.S. bond market may likely react negatively, interest rates may rise and the “recovery party” for many financial assets could become muted. Implications for Income Investors In a slowly improving economic growth scenario in which interest rates could rise from historically low levels, we believe income investors need to consider both interest-rate risk as well as credit risk as they assess their fixed-income portfolios. A way to limit interest-rate risk is to incorporate strategies with relatively short durations. Long-term U.S. Treasury bonds would seem to be the asset class to avoid, in our opinion. A way to manage or reduce credit risk is to invest in income sectors which, despite tightening in credit spreads over Treasuries of comparable duration, still offer spreads that are near or above their trailing long-term historical averages. Income sectors that fall into this camp include floating-rate loans, high-yield bonds, investment-grade corporate bonds issued by financial companies, seasoned commercial MBS and preferred stocks. (Notably, credit spreads for generic “agency” MBS are well below their long-term average.) Finally, with limited additional capital-appreciation potential available even from these attractive sectors, we believe income investors should look to the coupon as the primary indicator of a sector’s expected total return for 2010. On this basis, high-yield bonds continue to look interesting and appear poised, in our opinion, to “earn their coupon” of approximately 8%-9%. High yield has a credit spread near its long-term average, a relatively short duration, a deceleration in the pace of new defaults and expectations for falling default rates this year (i.e., low expected credit losses). Should the Fed raise the target federal funds rate faster than anticipated, floating-rate loans, with their ultra-short duration, could offer investors protection from rising rates and could become the sector of choice. We believe diversified strategies, which include the taxable sectors discussed above in a low-correlated, short- or limited-duration package, make sense for the current environment. Such strategies could also include an international component. To gain exposure to emerging/international fixed-income markets, one might incorporate a global macro approach with the flexibility to invest in either long or short positions in local market currencies or sovereign debt. On the tax-exempt side, the average yield on AAA-rated, long-term municipal bonds relative to those on Treasury bonds with comparable maturities is in the 90% range, near its trailing long-term average. Though long-term munis would appear to be fairly valued, one can’t ignore the possibility of further spread compression/price appreciation due to the likelihood that demand for long-term municipal bonds will grow from the prospect of higher individual tax rates in 2010-11 (it has already happened with the passage of Health-Care Legislation) and that supply will be reduced by the continuing issuÂance of Build America Bonds.2 Most importantly, following the implosion of many bond insurers, there is a scarcity of AAA-rated muni bonds. Despite this, the underlying quality of many rated muni bonds is high (either AA or A), and these currently offer credit spreads which are at least 40 percent higher than their historical average spreads over AAA-rated bonds. Despite continuing “headline risk” accompanying many unrated bonds and certain general obligation bonds, we believe that higher-quality essential-service revenue bonds in particular offer compelling yields for the risk assumed. Such potential for price appreciation combined with strong demand for tax-exempt investments should help offset the negative impact of a rise in long-term U.S. taxable Treasury rates in our opinion. At the short end of the municipal bond curve, muni ratios are not as compelling, so we believe it makes sense to consider bond strategies which seek to maximize after-tax total return by investing in both municipal bonds and short-term U.S. Treasuries/agencies. 1Standard & Poor’s 500 Index is a broad-based unmanaged market index of common stocks commonly used to measure the performance of the U.S. stock market. It is not possible to invest directly in an index. 2Build America Bonds are taxable bonds issued by state and local governments for capital projects for which they receive a new direct federal subsidy payment from the Treasury Department for a portion of their borrowing costs. The views expressed in this report are those of Eaton Vance and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investÂment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. Before investing, prospective investors should consider carefully the Fund’s investment objective, risks, charges and expenses. The Fund’s prospectus or summary prospectus, if available, contains this and other information about the Fund and is available through your financial advisor. Read it carefully before you invest or send money. Why Eaton Vance? Eaton Vance provides investment solutions to individuals and institutions, guided by the principles of fiduciary responsibility and our deep experience. Since its founding in 1924, Eaton Vance has held fast to Charles Eaton’s belief that “a well-rounded investment management organization is not engaged in a guessing game with other people’s money. It is doing a highly specialized professional job, endeavoring to apply knowledge, judgment and decisiveness in action.” The Company’s long record of providing exemplary service and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning individual and institutional investors.
Not FDIC Insured • Not Bank Guaranteed • May Lose Value (c) Eaton Vance Investment Managers
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